Devaluation of Naira

• Naira 101. In the interest of understanding how, why and when the Central Bank of Nigeria (CBN) devalues or revalues the naira, we thought we would take a step back and review Nigeria’s exchange rate policy. We know that Nigeria prefers a strong and stable naira, given its significant dependence on imports and desire for price stability. In the interests of a stable naira, the CBN manages the naira/dollar exchange rate within a narrow range that is reviewed on an annual basis. This year the prescribed target range is NGN150/$1 +/-3% (i.e. NGN145.50-154.50/$1). The CBN uses the wholesale Dutch auction system (WDAS) to supply dollars to banks, and manages the supply of dollars at bi-weekly auctions to keep the exchange rate within the target range. Banks submit their bids, and the CBN allocates dollars to the highest bidder, down to the level that clears the volume on offer, known as the marginal rate. The marginal rate is the lowest level at which the CBN will supply dollars, and is also referred to as the WDAS rate (as it is referred to in this report from here on). The WDAS rate is the exchange rate that the CBN tracks and aims to keep within its targeted range. Banks bid with the aim of securing the best (read lowest) rate for their customers, while trying not to bid lower than the marginal rate, otherwise they would be unsuccessful in their bid. However, if FX demand is strong, or there is a perception among the banks that the FX amount on offer may be tight, then bid rates creep up. For most of 2011, the WDAS rate has been in the upper part of the target band (NGN150/$1 +3%, or NGN150-154.5/$1), implying that FX demand has generally been stronger than supply. We see the CBN’s ability to sustain a strong and stable naira, and ensure the exchange rate does not breach the upper target band, as being dependent on the strength of its FX reserves position. Generally, central banks will defend a rate target until their FX reserves reach a floor level, below which the economy becomes vulnerable to external shocks.
• Why devalue? On 26 September, the WDAS rate rose to NGN155.02/$1, implying that the CBN had supplied dollars at a rate outside the target band for the first time in 2011. This suggested that the CBN was not willing to dip deeper into its FX reserves at the expense of maintaining the target band on that date. Subsequent calls for devaluation have been made by market for the following reasons:

1.     FX reserves have failed to recover in 2011, despite the relatively high price and stable production of oil. With the global economic outlook deteriorating, there are concerns that the CBN may not be able meet the FX demand required to sustain the exchange rate target band.

2.     The naira has traded in the upper band of the target range for most of 2011, implying demand pressure.

3.     The widening gap between the WDAS and interbank exchange rates, which peaked at NGN12.11 on 17 October, compared with the 18-month average of NGN2.5, suggests the local market’s FX demand is far stronger than the CBN and autonomous sources can supply, including export proceeds (see Figure 2).

The 26 September breach fuelled the argument for further devaluation; we assigned a 40% probability that the naira would be devalued to NGN155/$1 in 2012 in our report, Nigeria: Moving beyond the promises to deliver – The next 6-12 months are critical, published 1 September 2011 (click here to view the report).

• Why CBN Governor Sanusi Lamido Sanusi’s call for a modest devaluation to NGN155/$1 or NGN156/$1 may be achievable. Sanusi has been adamant that a stable exchange rate must be maintained in the face of calls for devaluation, and despite the IMF’s suggestion that the overvalued naira should become a more flexible currency. However, in early November, Sanusi signalled that devaluation was a possibility, although only a modest one. Why are the devaluations suggested by the Ministry of Finance in the medium term budget proposal, and Sanusi, so modest (to NGN153/$1 and NGN155-156/$1, respectively) – especially given that the naira fell to a low of NGN167/$1 on the interbank market on 10 October? Part of the answer is that the exchange rate that the authorities are referring to is the WDAS rate, the rate at which the CBN sells dollars to commercial banks, not the interbank rate. Moreover, the WDAS rate has only breached the target band at four of the 83 auctions YtD, and even then it fell to a low of NGN156.9/$1 – closer to Sanusi’s proposed mid-point exchange rate level of NGN155-156/$1 than to the interbank low of NGN167/$1. But one could argue that the stronger depreciation of the interbank rate, and the widening gap between the interbank and WDAS rates in late September and early October (we note that several EM currencies were very weak during that period), imply that the market is signalling strong FX demand pressure. This could suggest that the CBN and autonomous sources might not be able to meet demand (see Figure 2). The Nigerian authorities’ decision to allow only a modest devaluation suggests to us that they are confident that the CBN has the FX-reserve firepower to sustain a mid-point level of NGN155-156/$1 in 2012. Something that could mitigate a breach of the upper end of the 2012 target band is a widening of the target band vs 2010, as suggested by Sanusi. We explore the factors that could explain the CBN’s bullish stance and the risks to its position below. 

***Recap